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Investors Pouring Cash Into EM Bond Funds

Bond ETFs are expected to drive asset growth for exchange-traded products in the coming years. By some estimates, bond ETFs could have $2 trillion in assets under management by 2020. This year, bond ETFs have accounted for nearly a third of all inflows to exchange-traded products.

However, it is not just standard fare such as U.S. Treasuries or investment-grade corporates that are driving bond ETF asset growth. Amid anemic interest rates in the U.S., declining credit quality for some European sovereign issuers and improving credit quality in the developing world, emerging markets bond ETFs are attracting robust inflows in 2012.

That is not surprising given the decent yields that can be found on even some of the more conservative emerging markets bond ETFs. The iShares J.P. Morgan USD Emerging Markets Bond Fund (NYSE: EMB), the largest such ETF with $6.1 billion in AUM, has a trailing 12-month yield of 4.3 percent. The PowerShares Emerging Markets Sovereign Debt Portfolio (NYSE: PCY), EMB's primary rival, has a trailing 12-month yield of 4.7 percent. Both ETF hold dollar-denominated debt.

Year-to-date, EMB and PCY have easily outpaced more conservative bond funds such as the PIMCO Total Return ETF (NYSE: BOND), the Vanguard Total Bond Market ETF (NYSE: BND) and the iShares Core Total U.S. Bond Market ETF (NYSE: AGG) by wide margins.

As of July, emerging markets bond ETFs accounted for $15.5 billion of the assets in global fixed income exchange-traded products, according to iShares data.

The category has taken in over $6bn in net new assets already in 2012 and now accounts for 5% of the fixed income ETP universe, up from less than 2% going into 2010, according to a note by Dodd Kittsley, Head of Global ETP Market Trends Research for BlackRock (NYSE: BLK). BlackRock is the parent company of iShares.

ETF issuers have met investor demand for more emerging markets debt products with aplomg. As Kittsley noted, roughly 20 percent of the 57 emerging markets bond ETPs on the market debuted this year. These new funds offer more exposure to more than just dollar-denominated sovereigns and many are proving successful despite narrower focuses.

Emerging markets corporate debt has been one of the fast growing corners of the bond space over the past several years. As of May, all emerging markets corporate debt, including high-yield issues, had a total market value of $1 trillion, putting it on par with the U.S. junk bond market, according to Barclays.

Non-Dollar Issues
Due to improving credit ratings, strong government balance sheets and diminishing default risk, many investors have looked to bond ETFs denominated in local currencies as a way of hedging exposure to dollar-denominated assets.

These inflow statistics indicate investors are not shy about embracing bonds denominated in Chilean pesos and the Thai baht. In early May, the Market Vectors Emerging Markets Local Currency Bond ETF (NYSE: EMLC) had $743 million in AUM. As of October 26, that number was almost $927 million. The iShares Emerging Markets Local Currency Bond Fund (NYSE: LEMB) is just over a year old and already has more than $207 million in AUM. The WisdomTree Emerging Markets Local Debt Fund (NYSE: ELD), the first actively managed ETF to hit the $1 billion AUM mark, had $1.1 billion in AUM at the end of 2011, but that number is now close to $1.4 billion.

These statistics indicate investors are shaking off preconceived notions about emerging markets debt and realizing the asset class is not risky as previously believed. A vast majority of the issues held in the ETFs mentioned here are investment grade, adding to the allure for investors.

Another advantage for investors is low correlations. Over the past three years, PCY has a correlation to the S&P 500 of just 0.68. Over that time, including dividends paid, PCY has slightly outperformed the SPDR S&P 500 (NYSE: SPY) with significantly less volatility.